Michael
Oct 22nd 2008, 08:18 PM
Regulating Capitalism
The United States, Britain, Netherlands and Iceland, to name just a few, have all moved with unseemly haste to 'nationalize' some of the largest private banks in these nations - in order to prevent them from collapsing. Everywhere on the globe one looks right now, the picture is one of politicians using taxpayer funds (or more commonly, sovereign debt) to prop up the banking sector. The threat is that the financial crisis has had the potential to turn a cyclical recession into a deep and dark depression.
With the swift action of central bankers, political agreement and several trillion dollars of added sovereign debt, the worst of the crisis appears to have been averted. The financial house of cards upon which the whole of the world's economy and prosperity is built on looks like it is going to survive after all. We're still going into a recessionary period, but its not likely to be the massive decade long depression as may have been earlier feared (with some justifiable cause). Rumors of the demise of capitalism are obviously premature.
And now the well-fed pundits and commentators, politicians and bureaucrats, those that cheered capitalism on to the precipice (counting their dividends, fat salaries, kickbacks and windfall taxes every step of the way), are now wringing their hands about what to do about this failure of capitalism. They conclude that the much maligned 'Washington Consensus' is totally dead (without any evidence other than their own assertions). The question posed by these people is not 'how' to regulate or deregulate, but how much new regulations will be necessary? They speak of capping executive compensation or outlawing 'outsized' bonuses for high-flying stock-jockeys. They talk about making 'short-selling' illegal (especially the delightfully named 'naked shorts'). They talk about raising the capital reserve requirements of private banks. There is no shortage of ideas out there in how to tame the beast.
In my opinion, all of this talk is little more than misguided nonsense. These are just pet solutions that have been lying around for years and they bear no real or factual connection with the actual cause of the financial crisis in the first place. They are ideas that have been sitting on the shelf for years and are being suggested right now just because the 'political environment' is thought to be receptive to them right now. This is no different than the way the Bush Administration used 9/11 to dust off an old authoritarian wish-list of police powers (Patriot Act) that had been sitting on the shelf for many years (and voted down a couple times previously) and get it passed into law as a "response" to the challenge of 9/11.
Certainly something went wrong in the financial markets. That's pretty obvious. But just what did go wrong? To even think about proposing solutions, limits and/or regulatory safeguards upon the financial system, one has to have a good idea about what caused the problem. Otherwise one only chases the 'symptoms' and ignores the underlying disease - or we end up playing political-populism games that appeal to the masses but do more harm than good.
When one looks at the 'evidence' of the 'financial failure' the obvious culprits has to be the US mortgage-finance industry enabling financing for buyers of a house with zero down and negative amortization (interest only payments for the first year) and no verification procedure to establish actual income/assets of the buyer. That this was permitted to continue over a period of several years and in increasingly larger numbers is an absolute failure of the public regulation of mortgages. Mortgages are traditionally considered the most 'safe' of investment loans because a) they are government regulated and b) they are backed with the collateral of the property itself. This is a clear case of public regulatory failure - almost certainly a case of 'regulatory capture'. Congressional investigations into Fannie and Freddie have already started to show clears signs of the rot. Legalized corruption is the not-so-polite term for this game.
Another major element of the financial crisis appears to be the way the derivatives market was able to grow to un-imaginably massive size and complexity that defies most experts to understand. This market has grown up only over the last twenty some years as a truly 'new' financial instrument for hedging risk. It is a very complicated business, but it is major component for leveraging one's capital at a much higher than normal level without incurring any 'theoretical' increase in 'risk' (due to it being 'hedged' with derivatives). The massive size and mysterious complexity of derivatives trading and holdings is a major contributing factor to the 'crisis of confidence' for intra-bank lending. Once the long running bull market ended, some of these derivatives have turned sour on some banker/financiers and these banks realized just how potentially dangerous (and illiquid) they really are in a crisis - and thus, how little they actually do reduce risk, once the risk factors start to actually rise. Again, a clear case of public regulatory failure in permitting the unregulated usage of derivatives trading by banks and other financial institutions.
It is to be noted that although Wall Street is justifiably famous for inventing many new financial instruments, these techniques are always copied around the world remarkably quickly. Derivatives trading is a massive and global financial market.
The point here is that in both cases, the public already has established regulatory bodies overseeing both of these sectors. In almost every western nation, a government agency exists to monitor the private mortgage industry and another agency to monitor and supervise the banking/financial-trading sector. In most cases, they already have existing mandates or tools to have addressed both of these wildly dangerous practices. In almost all cases, these government agencies failed to do anything about the growing problem despite ample warnings over the last two-to-five years by a wide variety of experts.
My conclusion is we are looking at widescale government regulatory failure here. Institutional corruption - where the very agencies that are tasked by the public to monitor these sectors for public security end up being the vehicles by which the worst abuses are perpetrated. No less than Alan Greenspan was the one who took the fateful decision that 'there is no need to regulate derivatives trading'.
No new laws or regulations are needed here. Just a political willingness to root out institutional corruption built into the government process. The revolving door for 'employees' to go between government regulatory agencies and government contracting has to be addressed. Any regulatory changes that don't include addressing this key 'cause' of regulatory corruption is in my opinion, a waste of time.
The United States, Britain, Netherlands and Iceland, to name just a few, have all moved with unseemly haste to 'nationalize' some of the largest private banks in these nations - in order to prevent them from collapsing. Everywhere on the globe one looks right now, the picture is one of politicians using taxpayer funds (or more commonly, sovereign debt) to prop up the banking sector. The threat is that the financial crisis has had the potential to turn a cyclical recession into a deep and dark depression.
With the swift action of central bankers, political agreement and several trillion dollars of added sovereign debt, the worst of the crisis appears to have been averted. The financial house of cards upon which the whole of the world's economy and prosperity is built on looks like it is going to survive after all. We're still going into a recessionary period, but its not likely to be the massive decade long depression as may have been earlier feared (with some justifiable cause). Rumors of the demise of capitalism are obviously premature.
And now the well-fed pundits and commentators, politicians and bureaucrats, those that cheered capitalism on to the precipice (counting their dividends, fat salaries, kickbacks and windfall taxes every step of the way), are now wringing their hands about what to do about this failure of capitalism. They conclude that the much maligned 'Washington Consensus' is totally dead (without any evidence other than their own assertions). The question posed by these people is not 'how' to regulate or deregulate, but how much new regulations will be necessary? They speak of capping executive compensation or outlawing 'outsized' bonuses for high-flying stock-jockeys. They talk about making 'short-selling' illegal (especially the delightfully named 'naked shorts'). They talk about raising the capital reserve requirements of private banks. There is no shortage of ideas out there in how to tame the beast.
In my opinion, all of this talk is little more than misguided nonsense. These are just pet solutions that have been lying around for years and they bear no real or factual connection with the actual cause of the financial crisis in the first place. They are ideas that have been sitting on the shelf for years and are being suggested right now just because the 'political environment' is thought to be receptive to them right now. This is no different than the way the Bush Administration used 9/11 to dust off an old authoritarian wish-list of police powers (Patriot Act) that had been sitting on the shelf for many years (and voted down a couple times previously) and get it passed into law as a "response" to the challenge of 9/11.
Certainly something went wrong in the financial markets. That's pretty obvious. But just what did go wrong? To even think about proposing solutions, limits and/or regulatory safeguards upon the financial system, one has to have a good idea about what caused the problem. Otherwise one only chases the 'symptoms' and ignores the underlying disease - or we end up playing political-populism games that appeal to the masses but do more harm than good.
When one looks at the 'evidence' of the 'financial failure' the obvious culprits has to be the US mortgage-finance industry enabling financing for buyers of a house with zero down and negative amortization (interest only payments for the first year) and no verification procedure to establish actual income/assets of the buyer. That this was permitted to continue over a period of several years and in increasingly larger numbers is an absolute failure of the public regulation of mortgages. Mortgages are traditionally considered the most 'safe' of investment loans because a) they are government regulated and b) they are backed with the collateral of the property itself. This is a clear case of public regulatory failure - almost certainly a case of 'regulatory capture'. Congressional investigations into Fannie and Freddie have already started to show clears signs of the rot. Legalized corruption is the not-so-polite term for this game.
Another major element of the financial crisis appears to be the way the derivatives market was able to grow to un-imaginably massive size and complexity that defies most experts to understand. This market has grown up only over the last twenty some years as a truly 'new' financial instrument for hedging risk. It is a very complicated business, but it is major component for leveraging one's capital at a much higher than normal level without incurring any 'theoretical' increase in 'risk' (due to it being 'hedged' with derivatives). The massive size and mysterious complexity of derivatives trading and holdings is a major contributing factor to the 'crisis of confidence' for intra-bank lending. Once the long running bull market ended, some of these derivatives have turned sour on some banker/financiers and these banks realized just how potentially dangerous (and illiquid) they really are in a crisis - and thus, how little they actually do reduce risk, once the risk factors start to actually rise. Again, a clear case of public regulatory failure in permitting the unregulated usage of derivatives trading by banks and other financial institutions.
It is to be noted that although Wall Street is justifiably famous for inventing many new financial instruments, these techniques are always copied around the world remarkably quickly. Derivatives trading is a massive and global financial market.
The point here is that in both cases, the public already has established regulatory bodies overseeing both of these sectors. In almost every western nation, a government agency exists to monitor the private mortgage industry and another agency to monitor and supervise the banking/financial-trading sector. In most cases, they already have existing mandates or tools to have addressed both of these wildly dangerous practices. In almost all cases, these government agencies failed to do anything about the growing problem despite ample warnings over the last two-to-five years by a wide variety of experts.
My conclusion is we are looking at widescale government regulatory failure here. Institutional corruption - where the very agencies that are tasked by the public to monitor these sectors for public security end up being the vehicles by which the worst abuses are perpetrated. No less than Alan Greenspan was the one who took the fateful decision that 'there is no need to regulate derivatives trading'.
No new laws or regulations are needed here. Just a political willingness to root out institutional corruption built into the government process. The revolving door for 'employees' to go between government regulatory agencies and government contracting has to be addressed. Any regulatory changes that don't include addressing this key 'cause' of regulatory corruption is in my opinion, a waste of time.